The Federal Reserve is behind the inflation curve

Today’s shocking consumer price inflation numbers should be a wake-up call to the Federal Reserve. Indeed, they have to raise serious questions as to whether the Fed is falling behind the inflation curve at a time that the country is engaged in its largest peacetime budget stimulus and the economy is recovering strongly.

According to the Labor Department, in April consumer prices increased by a greater-than-expected 4.2 percent. This was their fastest pace of increase since 2008 and more than double the Fed’s 2 percent inflation target. Even stripping out volatile food and energy prices, the so-called core inflation rate increased by 3 percent.

Perhaps even more concerning than this week’s inflation number has been the steady rise in the market’s expectation as to future inflation. Unlike the Fed, which dismisses the recent inflationary buildup as due to transitory factors and to comparisons with last year’s low inflation numbers, the market fears that something more fundamental is going on with inflation. This has induced the market to raise its 10-year inflation expectation to more than 2 ¾ percent, which is the highest such reading in the past 10 years.

A principal factor that seems to underly the market’s increased inflation expectations is its judgment that the Biden budget stimulus has been excessive.

This is hardly surprising since the Biden administration is engaged in the country’s largest peacetime budget stimulus at the very time that the economy is already recovering strongly and the Federal Reserve still has its monetary policy pedal fully to the metal. It is also so engaged at a time that a lot of pent-up demand has been built up in the economy during the lockdown. That pent up-demand, which is reflected in a 30 percent growth in the broad money supply, must be expected to be released as the country returns to some semblance of normality after most of the population has been vaccinated. 

The inflationary consequences of Biden’s COVID-19 stimulus package can be gauged by comparing it to the estimated degree to which U.S. output currently falls short of the level that it could potentially reach at full employment. The COVID stimulus, together with the earlier bipartisan stimulus, would imply that this year the economy will receive around 13 percent of GDP in budget stimulus. Yet according to the bipartisan Congressional Budget Office, the country’s so-called output gap is only 3 percent, or less than one-quarter the size of the budget stimulus. 

The Federal Reserve is playing with fire by turning a blind eye to the inflationary pressures that are now clearly building up in the economy. Already over the past nine months, U.S. Treasury bond yields have increased at as fast a pace as they did during the 2013 Bernanke taper tantrum. Should markets perceive that the Fed is falling ever behind the inflation curve, they must be expected to demand even higher yields on their Treasury bond holdings.

Presently we seem to have bubbles in both the U.S. equity and housing markets, which have been caused by years of ultra-easy monetary policy and which have been premised on the assumption that interest rates will stay low forever. The last thing that the Fed can afford to allow is a sharp increase in market interest rates that might cause those bubbles to burst. Yet that is exactly the risk that the Fed is running if it is seen to be falling behind the inflation curve.

Another reason that the Fed might want to act in a pre-emptive way with regard to inflation is that it can ill-afford to allow inflation expectations to become entrenched. That would make it all the more difficult for the Fed to reduce inflation, and it would heighten the chances that the country will have a hard economic landing next year. 

John Maynard Keynes famously said, “When the facts change, I change my mind. What do you do, sir?” One has to hope after today’s inflation numbers that Fed Chairman Jerome Powell soon realizes that the inflation facts have changed and that he moves away from his mantra that he is not even thinking about raising interest rates. If not, we should brace ourselves for a hard economic landing next year.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.